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Satyajit Das: Is an Emerging Market Crisis Coming?


Many now fear a rerun of 1994's Great Bond Massacre, which triggered emerging market crises and a 10-year setback to many Asian economies.

Cheap Money, Expensive Problems

Debt levels in emerging markets have risen significantly, with total credit growth since 2008 in the range of 10-30% depending on country. Credit growth has been especially strong in Asia. Total debt to Gross Domestic Product (GDP) above 150-200% of GDP is now common. Credit intensity has also increased sharply. New credit needed to generate each extra dollar of GDP has doubled to around US$4-8 for each dollar of GDP growth.

Bank credit has increased rapidly and is above the levels of 1997 (as percentage of GDP) in most countries. There has also been rapid growth in debt securities issued by emerging market borrowers, in both local and foreign currencies.

Borrowing varies between sectors, depending on country. Consumer credit has grown strongly in many Asian countries and also in Brazil. Many corporations in China, South Korea, India, and Brazil are highly leveraged. Combined gross debts at India's 10 biggest industrial conglomerates has risen 15% in the past year to US$102 billion. Many borrowers are overextended with inadequate cash flow to meet interest and principal payments, especially in a weak economic environment.

With notable exceptions like China and India, government debt levels are not high. However, state involvement in banks and industry mean that effective level of government obligations is higher than stated.

Sustainable levels of public debt are lower for emerging market countries, given lower per capita income and wealth.

Banks and investors with exposure to emerging markets are at significant risk. Borrowing has been used, worryingly, to finance consumption, and to back investment in infrastructure projects with uncertain rates of return or speculation.

In many emerging countries, quasi-government bank officials have financed projects sponsored by politically connected businesses and elites. Lending practices have been weak, helping finance expensive property and grand vanity projects with dubious economics.

Many borrowers will struggle to repay the debt. Losses are currently hidden by an officially sanctioned policy of restructuring potential non-performing loans. Bad and restructured loans at Indian state banks have reached around 12% of total assets, doubling in the past four years.

Trouble Abroad, Trouble at Home

Short term foreign capital inflows have financed external accounts, masking underlying imbalances.

The current account surplus of emerging market countries has fallen to 1% of combined GDP, from around 5% in 2006. The deterioration is greater as large trade surpluses of China and energy exporters distort the overall result. The falls reflect slow growth in export markets, lower commodity prices, higher food and energy import costs, and domestic consumption driven by excessive credit growth.

India, Brazil, South Africa, and Turkey have large current account deficits, which must be financed overseas. India has a current account deficit of around 6-7% and a budget deficit (federal and state government) approaching 10% which requires funding. Countries dependent on commodity exports are also vulnerable given the fall in prices and anemic global economic growth.

Emerging countries require around US$1.5 trillion per annum in external funding to meet financing needs, including maturing debt. A deteriorating financing environment combined with falling currency reserves, reduced cover for imports and short term borrowings, declining currencies, and diminished economic prospects have increased their vulnerability.

The difficult external environment has highlighted longstanding structural weaknesses.

Investors fear that many emerging markets may be caught in a middle class income trap, where countries experience a sharp slowdown in economic growth when GDP per capita reaches around $15,000.

Emerging economics remain highly linked to developed economies, through trade, need for development capital, and the investment of foreign exchange reserves, totaling in excess of US$7.5 trillion. Weak growth in developed markets and decreasing credit quality of developed country sovereign bonds may adversely affect emerging markets. Emerging countries have also lost competitiveness as a result of rising costs, especially labor.

Investors are concerned about mal- and mis-investment. Trophy projects, such as the 2008 Beijing Olympics (costing US$40 billion), Russia's 2014 Sochi Winter Olympics (US$51 billion), and Brazil's 2014 football World Cup and 2016 Olympics, have absorbed scarce resources at the expense of essential infrastructure.

Income inequality, corruption, hostile and difficult business environments, excessive concentration of economic power in heavily subsidized state corporations, and political rigidities increasingly compound the problems of debt and capital outflows. Political instability exacerbates economic problems, for example in Brazil, Turkey, South Africa, and India.
No positions in stocks mentioned.

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